U.S. equity markets advanced in the second quarter, as modest economic growth, a Federal Reserve on hold, and rising commodity prices helped overcome concern on Britain’s vote to exit the European Union. Small-cap stocks outperformed during the quarter, recovering a portion of their underperformance in Q1. Energy and materials shares benefitted from rising commodity prices while utilities and other yield-oriented equities were helped by lower interest rates. In fixed income, interest rates declined as international investors were attracted to the positive yields offered by U.S. Treasuries and the Brexit vote attracted a flight-to-quality bid. Commodity prices continued their rebound with energy benefitting from slowing supply growth. Gold was again a strong performer as investors grew increasingly wary about ongoing monetary stimulus and the marginal cost for holding gold declined with lower interest rates.
The initial rush to safety following the Brexit vote and subsequent pledge by central bankers to provide the markets with liquidity caused government bond yields to fall further across the globe. According to The Wall Street Journal, over $13 trillion of bonds now provide investors with a negative yield. In other words, most governments in developed market countries are now paid to borrow money. This creates a very dangerous situation where governments are encouraged to borrow as much money as possible while investors are willing to purchase government bonds at elevated prices because of the implicit backstop provided by central banks. The resulting feedback mechanism has the potential to result in a government bond bubble of epic proportions. Calling a floor on interest rates is extremely challenging as rates can continue to decline as central bankers commit to purchasing an ever-increasing amount of assets regardless of the price they are required to pay. Rather than attempting to drink from this fire hose of liquidity, investors would likely be best served from watching this play out from the sidelines.
The decline in government bond yields has also likely contributed to higher equity prices and elevated equity valuation multiples. A formal degree in economics is not required to understand that when interest rates are near zero, investors will look to riskier alternatives such as high-yield bonds, real estate, or stocks in order to generate nominal returns, resulting in higher prices across asset classes. From a more technical standpoint, a decline in government bond rates also generally lowers the discount rate for all risky asset classes, which is calculated by adding a risk premium to the risk-free (government bond) rate. A lower discount rate increases the value of future cash flows and ultimately results in higher asset prices. U.S. investors looking for a nominal yield naturally turn to sectors such as utilities, real estate, and consumer staples where cash flows are traditionally more stable and predictable. Indeed, an index of utility stocks increased over 20% in the first half of 2016, REITs were up over 13%, and consumer staples rose over 10%. While we typically favor business that generates a steady stream of cash flows, in today’s environment most of these companies are trading at elevated prices that do not provide either considerable upside or a necessary margin of safety.
In addition, the rotation of assets from active management strategies into passive or index fund investing has resulted in a large pool of capital that is required to purchase equities regardless of the price paid. Some analysts estimate that index funds now represent over 30% of equity assets under management. As Charlie Munger noted, “Index funds will be permanent owners who can never sell. That will give them power they are not likely to use well.” Equity indices typically weight individual stocks by market capitalization. Thus, if a company becomes overvalued it will not only receive an outsized allocation within the index fund, but additional capital flows into passive strategies will further increase the company’s already stretched valuation. We also fear Mr. Munger might be underestimating the permanent nature of capital within index funds. As an example, recently a robo-advisor (an online wealth management firm) suspended redemptions for a short period of time after the Brexit vote. While this might have ultimately benefitted investors, the idea that a circuit breaker was needed at all highlights that the time horizon for many “long-term” investors might actually be quite short – especially when a period of volatility strikes the marketplace. The proliferation of index funds necessarily means that they are increasingly being utilized by less sophisticated investors, resulting in a market that is more susceptible both to periods of lofty valuations and to the ensuing market downturns.
[us_separator] The above post has been excerpted from a recent letter of Gate City Capital Management.
Performance for the period from September 2011 through August 2014 has undergone an Examination by Spicer Jeffries LLP. Performance for the period from September 2014 through December 2015 has undergone an Audit by Spicer Jeffries LLP. Performance for 2016 is unaudited. The performance results presented above reflect the reinvestment of interest, dividends and capital gains. The Fund did not charge any fees prior to September 2014. The results shown prior to September 2014 do not reflect the deduction of costs, including management fees, that would have been payable to manage the portfolio and that would have reduced the portfolio’s returns. Actual performance results will be reduced by fees including, but not limited to, investment management fees and other costs such as custodial, reporting, evaluation and advisory services. The net compounded impact of the deduction of such fees over time will be affected by the amount of the fees, the time period and investment performance. Specific calculations of net of fees performance can be provided upon request.